Supply Side Policy Period example essay topic

Fiscal policy refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth. When economists study fiscal policy, they usually focus on the federal government, although governments at all levels affect the economy. Fiscal policy and government policy are related to taxation and public spending. Fiscal policy and monetary policy, which is concerned with money supply, are the two most important components of a government's overall economic policy, and governments use them in an attempt to maintain economic growth, high employment, and low inflation.

Fiscal policy can be either expansionary or contractionary. It is expansionary or loose when taxation is reduced or public spending is increased with the aim of stimulating total spending in the economy, known as aggregate demand. Expansionary policy might occur when a government feels its economy is not growing fast enough or unemployment is too high. By increasing spending or cutting taxes, the government leaves individuals and businesses with more money to purchase goods or invest in new equipment.

When individuals or firms increase their purchases, they raise demand, which requires additional production, creating jobs and generating more spending. The result is higher employment and a growing economy. On the other hand, fiscal policy is contractionary or tight when taxation is increased or public spending is reduced in order to restrict demand and slow down the economy. A tight fiscal policy is more likely when inflation is high. A contractionary fiscal policy reduces the amount of money in the economy available for purchasing goods, thus decreasing spending, demand, and, ultimately, pressure on prices.

To determine its fiscal policy, a government must make judgments about a number of factors, including the level of economic growth or unemployment likely in the future. These factors will affect the amount of revenue raised through taxes and the amount of money required for government programs. Once these determinations are made, the government can decide how to raise revenue and how to allocate it. Revenue is generated through a combination of different taxes-for example income tax, sales tax, or customs duties-and can be allocated to build new roads, fund government programs, or to pay expenses such as government employees's al aries. Another important decision a government must make regarding fiscal policy is whether or not to run a budget deficit by spending more money than the government raises. Deficits can be financed in two ways-borrowing or printing more money.

If the government borrows money, it will decrease the supply of money available in the economy for lending, and the cost of borrowing money, the interest rate, may rise. If the government prints more money, it will increase the supply of money in the economy; without a corresponding increase in available goods, prices-and inflation-are likely to rise. Decisions on fiscal policy are inevitably influenced by political considerations, such as beliefs about the size of the role that governments should play in the economy, or the likely public reaction to a particular course of action. Few governments will find it easy to raise taxes or to decrease funding for programs that have strong support from the public, such as social security or defense.

Fiscal policy decisions can be influenced by other outside factors as well. In today's global economy, a government also needs to consider the fiscal policies of other countries, which may tempt companies to relocate by offering them generous tax programs or other government-controlled benefits. Some countries may find their fiscal policy decisions constrained by the requirements of the International Monetary Fund (IMF), which often grants aid packages subject to conditions relating to fiscal policy. The tools of fiscal policy that can be sorted into two categories are: automatic stabilizers and discretionary fiscal policy. Automatic stabilizers are revenue and spending items in the federal budget that automatically change with the ups and down of the economy to stabilize disposable income and, consequently, consumption and real GDP. For example, the federal income tax is an automatic stabilizer because (1) it reduces the drop in disposable income during recessions and reduces the jump in disposable income during expansions and (2) once adopted, it requires no congressional action to operate year after year, so it's "automatic".

But there is another, more automatic way that spending and taxation can influence the economy. Some kinds of taxes rise more than proportionately when income increases. A progressive income tax is an example of this. "Progressive" means that the tax rate is higher on higher incomes. Thus, when income in general increases, more people are in the higher tax brackets, and so the average tax rate is higher. Some kinds of transfer payments and government purchases rise when income drops.

Unemployment compensation and income supplements for poor people are examples, as are purchases of services for the poor. When income in general drops, there are more poor people eligible for these transfers and services, so spending on them increases. These taxes, transfers, and purchases are automatic stabilizers of the economy. To see why, think of what happens when the economy goes into a recession, perhaps because of a sudden drop in autonomous consumption. The progressive taxes drop even faster than income, and this decrease in taxes has a multiplier effect, partly offsetting the drop in autonomous consumption, so that equilibrium income doesn't drop as far or as fast as it could. Similarly, the transfers to and services for the poor increase, and these too have multiplier effects and tend to offset the drop in autonomous consumption.

Thus, equilibrium aggregate demand drops less than it would have dropped simply because of the decrease in autonomous consumption alone. The economy is more stable. Discretionary fiscal policy, on the other hand, requires ongoing congressional decisions involving the deliberate manipulation of government purchases, taxation, and transfers to promote macroeconomic goals like full employment, price stability, and economic growth. THE BALANCED BUDGET MULTIPLIER Two types of fiscal policy to combat a recession are increased government spending (holding taxes constant) and cutting taxes (holding government spending constant). In both cases, such a policy approach entails running a budget deficit (or decreasing the budget surplus). There is a third type of fiscal policy that can eliminate a recessionary gap without an increased budget deficit (or decreased surplus).

This is due to what is called the balanced budget multiplier (BBM). To use the BBM, government would increase spending (G) by the difference between the full employment level of output and income (Yf) and the equilibrium level of output and income (Ye). At the same time, taxes (T) would be increased by exactly the same amount, so that there is no increase in the budget deficit (or decrease in the surplus). This works the other way in a boom. An example is the year 1997 in the U.S.A. At the beginning of the year, our government was divided over plans to gradually reduce the government deficit to zero by sometime in the next century.

By the end of the year, the deficit was much lower than anyone had anticipated. This happened because, over the year, steady growth of production reduced unemployment to its lowest rate in twenty-five years. This increased growth raised tax revenues and cut transfers, reducing the government deficit. Incidentally, the multiplier theory tells us that the dropping deficit will also have slowed the growth of production, partly offsetting the rise in aggregate demand that would otherwise have occurred. We may also hope that the government deficits in recession periods will be offset by government surpluses in boom periods. This is called a "cyclically balanced budget", and probably is the only realistic kind of balanced budget.

Unfortunately, it is a potentiality -- a hope -- not a fact. Supply-Side Experiment The U.S. economy had cycled toward stagflation by the end of the 1970's (Mundell, 1990; Tregarthen, 1996). Keynesian demand-side policies were generally in effect during the period from 1932 until President Reagan began implementing the supply-side policies recommended by Mundell and monetarist policies recommended by Friedman (Mundell, 1990). Five decades of Keynesian policy applications pushed the U.S. economy through the inflationary cycle multiple times (Mundell, 1990). The cycling resulted in stagflation, a dilemma in which both inflation and unemployment rates are high (Tregarthen, 1996). Friedman advocated a monetarist approach to solve the high inflation problem (Friedman & Friedman, 1984), and Mundell argued for a supply-side approach, which primarily implied a lowering of tax rates to attack the high unemployment, low productivity problem (Mundell, 1990).

Mundell suggested a solution to the dilemma (Beman, 1984). Mundell's supply-side solution involved having monetary and fiscal policies work in opposite directions (Beman, 1984). Radically, Mundell suggested a tax cut combined with a tight money supply (Beman, 1984). Mundell supported Laffer's notion that the relationship between tax rates and tax revenues is curvilinear (Mundell, 1990). As tax rates rise, there is a rate past which tax revenues will begin to decline.

Marginal tax rates were raised to 60 percent and remained there for approximately fifty years (Mundell, 1990). The monetarists argued that these aggressive policies would increase investment and in the long-run would shift the supply curve to the right in the model of aggregate demand and aggregate supply, stimulating capital formation. Further, Reagan believed that lower interest rates coupled with investment tax credits, accelerated depreciation allowances, and a reduction in marginal tax rates would stimulate long-run aggregate supply (Mundell, 1990). A comparison of U.S. productivity, unemployment and inflation variables for the 1960-1982 demand-side period with the 1983-1998 supply-side period was conducted for the purpose of answering the following questions: 1. Have supply-side policies stabilized the U.S. economy in terms of productivity, inflation and unemployment rates? 2.

Have supply-side policies improved the U.S. economy in terms of productivity, inflation and unemployment rates? Analysis and Results Figure 1 affords a view of relative overall stability since 1960 in terms of three macroeconomic variables: percentage change in real gross domestic product (RGDP), percentage change in the consumer price index (CPI), and the unemployment rate (UR). A cursory review of the relationships indicates three distinct periods: 1.1960-1972, a relatively stable period with minimum variance 2.1973-1982, a relatively unstable period with maximum variance 3 1983-1998, a relatively stable period with minimum variance Although President Reagan took office in 1981, it took until 1983 for his supply-side policies to be implemented and take affect (Mundell, 1990). For this reason, the data set was divided into two periods: a predominately demand-side policy period (1960-1982) and a predominately supply-side policy period (1983-1998).

The data set analyzed includes annual percentage changes in the following macroeconomic variables: real gross domestic product (RGDP%), money supply (M 1%), consumer price index (CPI%), unemployment rate (UR%), industrial production (IR%), producer price index (PPI%), manufacturing capacity utilization (MCU%), and civilian employment (CE%). The first statistical comparison involved computation of overall variances (all variables included) for each period. This comparison is presented in Table 1. The supply-side period has a significantly smaller overall variance indicating that the supply-side period is the more stable period. Table 1 also includes variance and mean comparisons for each of the individual variables. A significantly reduced variance in the supply-side period is considered an indicator of a more stable U.S. economy.

Of the eight macroeconomic variables considered, one (M 1) indicated less stability during the supply-side period, one (CE%) indicated no change in stability, and the remaining six indicate improved stability during the supply-side period. Mean comparisons for three of the variables (CPI%, UR%, and PPI%) indicate an improved economy during the supply-side period. The remaining five variables indicate no significant change from the demand-side period and supply-side period. Apparently, the combination of supply-side policies with strict control of the money supply resulted in a more stable U.S. economic system. The reduced overall variance seems to support this conclusion. Further comparison includes correlation and regression analyses of selected macroeconomic variables for the two periods.

Potential lags were investigated. The following lags were determined to be strongest for 1960-1982 period and serve as the basis for correlation and regression comparisons. 1. Relation of money supply to inflation in the following year: M 1%t-1 to CPI%t 2. Relation of inflation to productivity in the following year: CPI%%t-1 to RGDP%t 3.

Relation of inflation to unemployment in the following year: CPI%t-1 to URt Correlation matrices for the periods are displayed in Table 2. For the 1960-1982 period, there is a significant, positive relationship between M 1%t-1 and CPI%t. The relationship turns to non-significant, positive for the 1983-1998 period. For the 1960-1982 period, there is a negative, significant relationship between CPI%t-1 and GDP%t.

The relationship is non-significant, negative for the 1983-1998 period. For the 1960-1982 period, there is a significant, positive relationship between CPI%t-1 and URt. The relationship remains significant, positive for the 1983-1996 period. All three relationships are significant with the expected signs for the demand-side period; however, only the CPI%t-1 and URt relationship remains significant in the supply-side period.

Fed Chairman, Alan Greenspan, has alluded to the possibility that the U.S. economy is structurally changed. These results lend some support to his contention. Results of the regression analyses for the three primary relationships are presented in Table 3. All three models for the demand-side (1960-1982) period were found to be significant with the expected signs.

The M 1%t-1 and CPI%t regression indicates a strong, positive relationship between the two variables. The CPI%t-1 and GDP%t regression indicates a strong, negative between the two variables. The CPI%t-1 and URt regression indicates a strong, positive relationship. An increase in the money supply predicts an increase in inflation one year later. An increase in inflation predicts decreased productivity and increased unemployment one year later.

Models one and two (M 1%t-1 and CPI%t; CPI%t-1 and RGDP%t) lose their significance for the supply-side (1983-1998) period. Only the CPI%t-1 and URt regression model remains significant. One apparent result of the supply-side strict monetary control policies was to break the relationships between changes in the money supply (M 1%t-1) and inflation (CPI%t) and between inflation (CPI%t-1) and productivity (RGDP%t). The relationship between inflation and unemployment (URt), though somewhat weaker, remains significant.

See Table 3 for results CONCLUSIONS Overall variance, correlation and regression comparisons yielded the following results: 1. The combined overall variance for the inflation, productivity and unemployment rate variables was reduced significantly during the supply-side (1983-1998) period. 2. Correlation coefficients that were strong for the demand-side (1960-1982) period lessened to non-significance for the supply-side (1983-1998) period with one exception, inflation and unemployment.

3. Regression relationships that were strong and significant for the demand-side period lessened to non-significance for the supply-side period with one exception, inflation and unemployment. Generally, the expected macroeconomic links between monetary expansion and inflation, inflation and productivity, and inflation and employment established during the demand-side period broke down in the supply-side eighties and nineties. The supply-side fiscal policies advocated by Mundell (1990) and the strict monetary controls recommended by Friedman have led to a more stable, healthy economy in the U.S. Macroeconomic indicators remained stable and positive during the first two quarters of 1999 with (1) a national unemployment rate reported at 4.3 percent, (2) inflation growing at an annualized rate of 2.5 percent, and (3) real gross domestic product growing at an annualized rate of 2.9 percent (National Economic Trends, 1999). The supply curve was shifted to the right through the supply-side fiscal incentives of reduced taxes and deregulation resulting in a concomitant shift to the right of the demand curve. Control of government spending coupled with strict control of the money supply allowing it to increase only to match increases in productivity has brought inflation to near zero levels.

Candidate Reagan's plan called for increased productivity and reduced inflation. Both objectives were achieved.